Thank God for the European commission and its competition chief, Neelie Kroes. Without her persistence, Britain would have one of the most concentrated and least competitive banking systems in the world. Even after yesterday's announcement about the "break-up" of Lloyds and RBS in return for another £40bn of government investment, Britain has five mega banks and a handful of minnows. Big remains beautiful.

But big is not beautiful. For decades the story has been that big banks are good for financial stability and for the economy. The bigger the bank, it was argued, the more diversified its risks and the better role it can play as a shock absorber when the markets crash or confidence evaporates. That might have been true before the emergence of a global capital market, but we now know that giant banks are what the Bank of England director, Andrew Haldane, calls super spreaders of financial contagion. They threaten financial stability.

Nor are big banks good for the economy. They are not especially efficient as organisations, but they can lend enormously to allow companies to grow and invest – except that is not what they do. British bank lending is almost entirely mortgages, consumer credit, and commercial property lending. There is a tiny amount of working capital supplied to British companies, but almost no lending to support company innovation and investment. British banks never did this much, but they do even less today – an important reason why Britain has such an unbalanced economy and is slower to emerge from recession than others.

Yet the opportunity for reform has been funked, despite yesterday's brouhaha. The "break-up" is no such thing. It is certainly better than nothing that around 1,000 branches – 7% of the total – are being moved from big bank ownership to a new life either as independent banks or under new ownership. But only 18 months ago we had the independent Alliance & Leicester and Bradford & Bingley, now swallowed up by Santander; HBOS, now part of Lloyds; and a much larger Northern Rock. Britain's banking market will be much more concentrated in the years ahead than it was – and that hardly represented the acme of competitive perfection.

Yet even this small move provoked howls of protest – Stephen Hester, CEO of RBS, complaining of Brussels' meddling. On Monday Josef Ackerman, CEO of Deutsche Bank – spokesman-in-chief for big banks – declared political pressure to cut the banks down to size was "totally misguided".

The bankers are wrong. The reason strikes at the core of their business model and their former capacity to build such leveraged, high-risk balance sheets – justified by conventional mathematics and the development of a risk management concept called "value at risk". It was predicated on the assumption that improbable but nonetheless dangerous financial events happen rarely because financial markets are efficient, and thus it is abnormal for exceptional losses to occur very frequently.

Both assumptions were wrong. The prices of financial assets are highly interdependent, not least because they are bought and sold by human beings prey to emotional irrationalities. Consequently, exceptional events happen much more frequently. Big banks turn out to be a menace – because when hit by improbable but statistically predictable events they collapse, and the cascade effect of their size brings others in the network down. Hence the impact of Lehmans – and what would have happened had the government not bailed out RBS and Lloyds? It is not just that they are too big to fail; the incidence of events that will make them fail have a much greater likelihood than conventional risk models have predicted. This is the great truth about the financial crisis that is too little appreciated.

We need to create smaller banks with more capital supporting them, and the banks themselves need to have multiple bulkheads like big oil tankers. If the ship springs a leak in one bulkhead, the others are sealed; it floats. If there are no bulkheads, the water spreads and it sinks. Thus the case for creating banks with multiple "bulkheads", splitting their functions up – another proposition that the banks oppose, and to which I am becoming increasingly attached the more is disclosed about the crisis.

The big banks' risk models are defunct. The only way the interbank markets function at all is because of tax-payer guarantees. The cost of borrowing has dropped dramatically as a result, widening margins – so the Hesters, Daniels and Ackermans think they can return to business as usual. They cannot. That way lies ruin.

The shame is that Neelie Kroes could not persuade European governments to join with her to have a bank-busting moment across the EU. We could have created smaller banks that set out to take more risks supporting innovation and investment – but with greater capital and more "bulkheads". Such a move would have threatened business as usual in the City, which is lobbying for as little action as possible. It has succeeded – and the taxpayer has little to show for the enormous investment. There is more to the British economy, though, than backing Big Finance and its fabulous, undeserved salaries.